Mr. Mizuno Retires (Part Two of Two)

Beginning in the early 1990s, following the collapse of a colossal housing and stock market bubble, Japan began to run large government deficits. It has remained in deficit ever since. The gross government debt/GDP ratio has thus risen relentlessly and is around 200% today. Ouch! (Net debt/GDP, incidentally, is much lower, at about 100%. More on that below.)

How rapidly is this debt growing? Well, according to the IMF, Japan ran a deficit of about 9.6% in 2010, slightly below the 10.2% and 11.1% deficits in the US and UK last year, although this is at a slightly higher rate than in the euro-area. Perhaps a better way to think about Japan’s government deficit and debt servicing costs is to look at what economists and sovereign debt analysts call the cyclically-adjusted primary balance (CAPB), which is the deficit adjusted for the business cycle, minus interest payments. As such it can be thought of as a longer-term “core” measure of the deficit. If the CAPB is positive, then this implies that your debt servicing costs are trending down rather than rising. Also according to the IMF, Japan is currently running a CAPB of 6.2%, slightly lower than that of the US, at 6.5%, although slightly higher than the UK, at 5.4%. (The euro-area looks somewhat better on this measure.) So while Japan’s public debt situation is serious and growing, it is at least not growing more rapidly than either the US or UK. And in the former case, a great deal of new stimulus has just been thrown at the economy in the form of tax cut and unemployment deficit extensions, which practically ensure an elevated US deficit over the coming year or two. Yes, as it stands now, Japan’s government debt/GDP ratio is more than double those of the US, UK and most of the euro-area, for example. But let’s put this in perspective: First of all, who owns this debt? Well guess what, the Japanese do. That’s right, their government debt is held almost entirely domestically. They basically owe their public debt to themselves. Now that doesn’t mean that this debt isn’t an issue, but it’s not the same sort of issue as if your government debt is held largely by foreigners, who might decide to sell that debt someday to buy some other country’s debt or to finance domestic investment or consumption. This is a potential risk with the US, which relies on foreigners to finance a substantial portion of its government debt.

Having discussed government finances, this brings us to the most important point of all, which is to compare the entire Japanese economy, public and private, to those of the West. As a legacy of decades of large trade and current-account surpluses with the rest of the world, Japan has a cumulative net foreign credit position of some 57% of GDP, whereas the US and UK have net foreign debt positions of around 19% and 22%, respectively, with the euro-area roughly in balance. This is reflected in part in Japan’s large official foreign exchange reserves of just over $1tn, the bulk of which are held in the form of US Treasury securities. (The US and UK have essentially no foreign exchange reserves. The euro-area has some $200bn.) Now, why are these figures so important? Think about it: If you are approaching retirement, do you want to owe other people money, or do you want them to owe you? Japan may be an aging society but it is an aging society with a private sector that has saved prudently for retirement! Japan may have a huge government debt but it can service that debt for an extended period by gradually winding down its massive net foreign credit position.

The US has Been Borrowing Money From Abroad for a Generation

But wait, what does this imply? If Japan is now beginning to gradually “dis-save” in this manner, gradually selling off its large accumulated holdings of foreign assets to service its domestic debts, what is going to happen to interest rates and currencies? Well, if Japan is winding down its holdings of US Treasuries and exchanging the proceeds for yen cash to service Japanese government debt then, other factors equal, US Treasury yields are going to rise and the dollar fall versus the yen. Rising yields will crimp US growth and a weaker dollar will reduce US purchasing power, such that demand for Japanese exports will likely decline. But then, if Japan is indeed dis-saving, it will be less reliant on exports, especially to the US, which in any case is declining in importance for Japan as its Asian neighbors are growing much faster. Viewed in this way, Japan’s demographic issues, far from being automatically yen negative, could in fact be yen positive, at least for a period of some time. Yes, Japan’s potential growth rate may be in gradual decline for demographic reasons, but at least they have a huge stock of private savings.

And as they wind down their holdings of foreign assets, stocks and bonds, and exchange the proceeds for yen, the value of those assets will come under downward pressure, as will their currencies of issue versus the yen.

One objection that might be raised at this point is that perhaps, notwithstanding a large net foreign credit position, Japan’s private sector has nevertheless not saved enough to fully fund its demographic-driven future liabilities. Fair enough, in fact we would agree that it hasn’t. But please answer this: Who has? Please name one large developed country that has fully-funded future liabilities, public and private. Can’t do it? Well that’s because there isn’t one! (There are some smaller ones, including Norway for example.) The US, with estimated future public liabilities of some five times GDP may be the most egregious example of massive, largely unreported off-balance sheet obligations such as Medicare, Social Security, etc, but it is nevertheless in good company with the UK and several euro-area countries.

Moreover, whereas Japanese corporations and also the public sector tend to have essentially fully-funded pension plans–the primary explanation for why Japan’s net public debt is so much lower than gross public debt–the same cannot be said for most US, UK or European corporations and public sector entities, many of which are already facing pension funding problems, requiring additional debt issuance just to make interest payments! Now how on earth is that new debt going to be serviced? We’d much rather be in line to receive a fully-funded Japanese pension–despite the demographics–than a Ponzi-style pay-as-you-go and hope-the-stock-market-always-rises western-style one!

Another point that is worth mentioning here is that, as mentioned in our narrative above, the normal Japanese retirement age is only 60, yet the Japanese are generally much healthier and longer-lived than their western counterparts, and also tend to have a stronger work ethic, implying that it could be quite possible to extend the retirement age substantially, thereby generating additional income and holding down retirement costs. That could have a huge impact on their ability to deal with their demographic problem, at least for a number of years. Certain western countries have large and growing health issues which suggest that, even if retirement ages are extended somewhat, they may not be able to reap the same degree of productivity benefits as Japan.

Finally, much ridicule has been directed at Japan’s relentless and ultimately futile attempts at fiscal stimulus over the past two decades. But consider: Rather than transfer cash to households to spend on food, or vacations, or whatever, stimulus in Japan has generally taken the form of investment in infrastructure, such as “bridges to nowhere”, for example. Now we are no fans of misguided Keynesian stimulus, which at the extreme is as counterproductive as paying people to dig holes and then fill them up again, but if we had to, we would probably choose to own a bridge to nowhere or other such infrastructure rather than an empty hole in the ground. The former might at least be of some value, if less than what a profit-seeking corporation would have built with the capital instead. If Japan does get into budget difficulties down the road that cannot be fully addressed by increasing the retirement age; raising taxes; restructuring pension liabilities; drawing down net foreign savings, etc, then Japan has much public infrastructure which could be privatized to raise funds. After all, this has been going on in western economies for years. So much public infrastructure has already been sold off in some places that there is not much left. In the US, even state capitol buildings have been sold (and leased back) to raise revenue for cash-strapped governments! Japan has not even begun to go down this road, which given the huge numbers of “bridges to nowhere”, might be long indeed. The West, however, has mostly reached the end, leaving it with fewer options.

We all know what happens to countries that have borrowed too much and can’t pay it back. They devalue their currencies, default on their obligations, or both. However, if you owe the debt largely to foreign, rather than domestic investors, isn’t it politically somewhat more expedient to devalue, than to default? As a result, might the political temptation to devalue unfunded liabilities away be much greater in the US than in Japan? We believe so. Perhaps someday there is going to be some sort of restructuring of Japanese government debt, but as they owe it primarily to themselves and are only now just beginning the long process of dis-saving, which implies less reliance on exports, we don’t see nearly as much potential risk of a pro-active devaluation of the yen as we do for, say, the dollar or sterling, where savings rates and exports, in fact, need to rise dramatically to rebalance those economies. It is not just the economics of foreign asset sales that favor the yen over the dollar but, at the margin, also the politics.

We do sympathize with the Mr. Mizuno of earlier narrative. He is perfectly justified in having some serious concerns about the future of his country. But it is the now-retiring baby boomers of the West who, in our minds, have reason to be outright terrified.

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]

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About John Butler:

John Butler has 17 years experience in the global financial industry, including European and US investment banks in London, New York and Germany. Recently, he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, responsible for development and marketing of proprietary, index-based quantitative strategies in global interest rate markets. Prior to DB, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where his team was voted #1 by Institutional Investor. He has contributed to financial publications including the Financial Times, Wall Street Journal, Boersenzeitung and Handelsblatt.